In an effort to stimulate the economy the Federal Reserve lowered their fed funds target to an effective rate of zero percent. When this extreme accommodative maneuver did not provide the desired effect on the economy, the Federal Reserve found they were in need of an additional and potentially more effective tool. To address this need the Federal Reserve initiated the quantitative easing option.

According to Wikipedia, the term quantitative easing “refers to the fact that a specific quantity of money is being created; 'easing' refers to reducing the pressure on banks. A central bank can do this by using the new money to buy government bonds (Treasury securities in the United States) in the open market; or by lending the new money to deposit-taking institutions; or by buying assets from banks in exchange for currency; or any combination of these actions. These have the effects of reducing interest yields on government bonds and reducing interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying bodies. In very simple layman's terms, the central bank creates new money out of thin air. It then uses this money to buy what is essentially an IOU, usually from the government. This money is credited to the bank account of the seller of the IOU. The private bank can then use this money as a basis for creating more new money by increased lending. The aim of quantitative easing and the follow on process of deposit multiplication is to increase the amount of money in circulation by an increase of credit and thus stimulate the flow of money around the economy by increased spending. The usual method of regulating the money supply is by setting interest rates. Quantitative easing is a solution when the normal process of increasing the money supply by cutting interest rates isn’t working and most obviously when interest rates are essentially at zero and it is impossible to cut them further.”


On December 16th of last year the Federal Open Market Committee took the drastic step of lowering interest rates by 75 to 100 basis points to a range of zero percent to 25 basis points. This unprecedented cut in interest rates proved to not be enough to quickly revive the U.S. economy. Since then it has become more evident that more stimulus, other than just zero short term interest rates is needed. Late last year there were some analysts that were thinking that the Federal Reserve should start buying Treasury issues directly from the Treasury Department in order to keep long term interest rates low. This in turn should put downward pressure on mortgage rates, which should then stabilize the beleaguered housing market. This feeling was encouraged when the Federal Open Market Committee mentioned the possibility establishing a policy of quantitative easing in their statement following the Federal Open Market Committee meeting on January 28th. Within their statement they said “the Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”

                                                               
           
Chart provided by APEX

The Federal Reserve finally made good on their “promise” on March 18th when they announced that they would buy as much as $300 billion of Treasuries over a six month period. This powerful form of accommodation was done in light of a worsening recession, which has resulted in the unemployment rate advancing to a twenty-five year high of 8.1%. This easing move on the part of the Federal Reserve follows the March 5th Bank of England’s Monetary Policy Committee announcement of a quantitative easing policy in the U.K. At that time the Bank of England said they were initiating a program of quantitative easing by purchasing 75 billion pounds of mostly public sector debt over the next three months. In addition to the Federal Reserve and the Bank of England, other major central banks that have recently initiated a quantitative easing policy, or a near quantitative easing policy, are the Bank of Japan and the Swiss National Bank. More recently the European Central Bank has hinted at a similar policy even though the euro zone central bank, according to their charter, is expressly prohibited from buying debt directly from the government.


As the global economy continues to remain in a precarious state, the need for an extremely more accommodative Federal Reserve becomes more urgent. The unprecedented massive amounts of economic stimulus plans, bailout plans, “bad bank” proposals, tax code changes, along with a drastically reduced fed funds target from the Federal Reserve and now quantitative easing will not be sufficient, at least in the short term, to offset the destruction of wealth that has taken place as a result of the subprime mortgage related crisis. While most of the additional accommodation from the Federal Reserve and other major central banks is well intended, it appears to have been too little and too late. 

However, it is likely that the ultimate weapon of accommodation that the Federal Reserve has recently employed, quantitative easing, will be the one that ultimately turns this economy around. Expect this bull market in the Treasuries to continue for the next several months. Many analysts believe that there is a “floor” under the market for Treasuries as long as the Federal Reserve maintains their policy of quantitative easing.  Within the Federal Reserve’s initial announcement of their quantitative easing policy they stated that their Treasuries purchase program will continue for a six month period. At least for now, it is probably a good idea to buy what the Federal Reserve is buying, especially when they have committed to a long term purchase plan that involves billions of dollars. Continue to trade Treasury market futures from the long side as the pressure on the Federal Reserve intensifies to maintain an ultra low interest rate environment.

For more information about this article, please contact Alan Bush at 1.800.243.2649 or send him an email at alan.bush@archerfinancials.com.

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